September 4, 2018

ESG Index Geared to Structured Products

A new index offers investors the possibility to combine sustainability criteria with a high dividend yield and low volatility profile, marrying popular portfolio characteristics with idiosyncratic benefits. 

The iSTOXX® Europe ESG Climate Awareness Select 50 Index tracks the corporate leaders following environmental, social and governance (ESG) principles. The index’s composition methodology then filters for stocks with high dividend yield and low volatility, factors that traditionally result in better risk-adjusted returns. 

The strategy is particularly attractive for issuers of structured products (SPs), as the high dividend yield/low volatility of the underlying lowers the price of the option used to construct the product. The lower the option price, the higher the participation of the SP buyer in the underlying’s return. This pricing optimization has made a success of the STOXX Select suite of indices among SP issuers.

An additional benefit comes from the potential returns of high dividend/low volatility stocks, which have outperformed in the long run due to their more stable businesses and smaller potential drawdowns. 

Using data from the world’s leading ESG overseers

The iSTOXX Europe ESG Climate Awareness Select 50 Index is derived from the STOXX® Europe Climate Awareness Ex Global Compact Controversial Weapons & Tobacco Index, which currently has 381 components and is constructed based on the input of some of the world’s leading climate change overseers and researchers. 

The parent index includes companies that have considered the implications of climate change or are advancing the implementation of renewable-energy initiatives, according to the thorough environmental data rankings from CDP. It excludes firms deemed in contravention of UN Global Compact Principles by Sustainalytics, as well as those involved in controversial weapons activities, and in the coal and tobacco sectors. 

Creating the selection list

Within the benchmark universe, the following selection filters are applied:

  •  The 10% of constituents with the highest carbon footprint as measured by CDP are excluded.
  •  Companies with low E, S or G Sustainalytics scores are excluded. 
  •  Companies with low trading volume and frequent trading suspensions are excluded.

A final screen applies quantitative criteria that analyze renewable energy programs in place at each company, as well as green energy use, filtering out stocks that don’t score high in at least one of the two. This tilts the portfolio towards businesses committed to and progressing in transitioning to renewable energy consumption. 

This first selection round addresses a growing demand from investors to incorporate climate change awareness within a broader ESG factor investment.

This is also the first time STOXX combines scoring data from CDP and Sustainalytics in a single index.

Applying the dividend and volatility filters

Finally, the high dividend/low volatility screens are applied. This is done in a two-way process: in a first step the top dividend payers are retained, and from those, the 50 stocks with the lowest volatility make the final cut. The percentage of companies being excluded from the total number is the same one in both steps. 

Caps on industry representation are in place to uphold the diversification of the index. 

The result is a portfolio consisting of 50 European companies that excel with regard to sustainability principles and combating climate change. These are the pioneers laying out frameworks that are conducive to fair and efficient operations and that address potential sources of business risk.  

The index will be the underlying for a new structured product issued by Morgan Stanley.

Two trends of modern investing

Strategies combining ESG and smart beta are gaining ground as more asset owners demand responsible investments and the rise of factor investing continues unabated. More than a quarter of the world’s $88 trillion assets under management were invested according to ESG principles as of 2017, according to a report last year.1

The iSTOXX Europe ESG Climate Awareness Select 50 Index utilizes both innovative approaches – ESG and smart beta – to generate efficient pricing for structured products and offer a portfolio with strong positive performance drivers.

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Institutional Investor, ‘McKinsey: ESG No Longer Niche as Assets Soar Globally,’ Oct. 27, 2017.